Question

1. Chin Hee and three of his friends from college have interested a group of venture capitalists in backing their business idea. The proposed operation would consist of a series of retail outlets to distribute and service a full line of vacuum cleaners and accessories. These stores would be located in Kuantan, Ipoh, Kota Bharu and Johor. To finance the new venture two plans have been proposed:

• Plan A is an all-common-equity structure in which RM2,000,000 would be raised by selling 80,000 shares of common stock.
• Plan B would involve issuing RM1,000,000 in long-term bonds with an effective interest rate of 12 percent plus another RM1,000,000 would be raised by selling 40,000 shares of common stock. The debt fund raised under Plan B has no fix maturity date, in that this amount of financial leverage is considered a permanent part of the firm’s capital structure.

Chin Hee and his partners plan to use a 40 percent tax rate in their analysis, and they have hired you to do the following:

Required:

Find the break-even EBIT (earnings before interests and taxes) associated with the two financing plans.                                                                                        

Answer 1

Under Plan A (All common equity structure)=No of common stock outstanding [N_e ]= 80,000

Under Plan B (with leverage)

No of common stock outstanding [N_d]= 40,000

Interest expense= 12% *1000000=RM 120000

Now,formula at which EBIT will be same under both plans, that is breakeven EBIT can be ascertained by EBIT -EPS analysis the formula for which is as stated below:

(EBIT-Interest)* (1-tax rate)- Preference Dividend/ No of common stock outstanding under equity plan [N_e ]

=(EBIT-Interest)* (1-tax rate)- Preference Dividend/ No of common stock outstanding under leverage [N_d]

Putting the values,

(EBIT-0)*(1-0.4)-0/80,000=(EBIT- 120,000)*(1-0.40)-0/40000

or, 0.6 EBIT/80,000=0.6EBIT-72,000/40000

or,0.6 EBIT/2=0.6EBIT-72000

or, 0.3EBIT=0.6EBIT-72000

or, 72000=0.6EBIT-0.3EBIT

or, 72000=0.3EBIT or, EBIT=72000/0.3= RM 240,000.

The Breakeven EBIT for both the options is RM 240,000.